As of 1 January 2018, an updated standard will become effective under IFRS 9, replacing much of IAS 39 Financial Instruments: Recognition and Measurement.1 Under the new standard, losses on debt-type instruments will need to be recognized earlier, while forward-looking information will need to be incorporated into the modelling of those losses. Under IFRS 9, for any loan carrying a provision amount, by definition, expected losses will be quantified at inception and will be updated periodically, whereas losses were accounted for as, and when, they occurred (‘backward-looking approach’) under previous accounting. The new standard aims to avoid procyclical lending and asset price bubbles that were deemed the primary cause of the 2007–2008 financial crisis and, simultaneously, it aims to give readers of financial statements a better appreciation of an entity’s credit-risk management processes.

Adapting to the new standards will present a challenge for financial institutions and corporations alike. Organizations will need to update credit-risk management policies and procedures to accommodate the new standards. The earlier recognition of losses could affect the level of regulatory capital needed for credit-risk purposes. Additional historical data will need to be compiled and warehoused, loan covenants will need to be reviewed and forward-looking econometric models or forecasts will need to be used. Furthermore, organizations will need to change information systems and reporting tools. However, the introduction of the new risk-management processes can also represent an opportunity to replace outdated internal risk-management systems.

It is worth emphasizing that IFRS 9 will need to be applied retrospectively (i.e., there is no grandfathering for existing financial instruments at the date of initial application), except for hedging. Nevertheless, the new standard does include certain transition provisions designed to provide some relief to entities adopting IFRS 9, particularly if an entity would bear an undue cost or effort to obtain reasonable and supportable information.

In the following, we will discuss the main aspects of IFRS 9 and the implications for the entities affected by it.

Fair value reported in profit and loss (FVPL): The asset is measured at fair value, and changes affect the profit and loss statement (P&L).

Fair value reported in other comprehensive income (FVOCI): The asset is measured at fair value, and changes affect the other comprehensive income initially.

Amortized cost: An asset is measured at the amount of initial recognition minus the principal repayments, plus or minus amortization minus loss allowances.

The use of one of these three categories is a function of an entity’s business model and the characteristics of the contractual cash flows associated with each financial asset. Unless certain restrictive criteria are met, the new standard requires entities to recognize changes in the FVPL as they arise. Specifically, the following two criteria must be met simultaneously for an instrument to qualify for measurement at amortized cost designation for any given financial asset:2

The objective of the entity’s business model is either to hold the asset in order to collect contractual cash flows or both collect contractual cash flows and sell the asset (‘the Business Model test’).

The contractual cash flows of an asset are solely payments of principal and interest on the principal amount outstanding (‘the SPPI test’).

To be able to classify a financial asset in the FVOICI category, the Business Model test noted earlier is expanded so that the objective of holding the asset is not only to collect contractual cash flows but also to sell the financial asset. If any of these criteria are not met, then the asset must be measured at FVPL. This simplification has the obvious drawback of increasing the volatility of the P&L.3

IFRS 9 recognizes that in very rare circumstances, cost might be an appropriate estimate of the fair value of an instrument. Examples of such cases are instruments for which insufficient up-to-date information is available (i.e., illiquid in the market), or where the range of possible fair value measurements is particularly wide and cost is the best estimate of value within that range. However, the new standard also provides indicators to the contrary, outlining circumstances where cost might not be representative of fair value.

Finally, at initial recognition, an entity may decide to bypass the guidance above and simply opt to irrevocably classify a financial asset under the FVPL category (the so-called fair value option), provided that doing so results in more relevant information. This option is only available if the use of FVPL would eliminate or significantly reduce a measurement or recognition inconsistency (sometimes referred to as an ‘accounting mismatch’).

Impairment of Financial Assets Expected Credit Losses
Probably the most significant change introduced by IFRS 9 is the concept of expected credit losses (ECLs). The ECL model affects only the subsequent measurement and impairment of financial assets that are classified under either amortized cost or FVOCI, not instruments that are measured at FVPL.

In general, ECLs are defined as the weighted average of credit losses where the weights are based on the respective risks of a default occurring. A credit loss, in turn, is defined as the present value of the cash shortfall arising from the difference between the contractual cash flows and the cash flows expected to be received by the entity over the expected life of the financial instrument, using a discount rate as prescribed by the standard. The concept of expectation is a statistical notion defined as the probability-weighted average of possible outcomes (in this specific case, credit losses). From a practical standpoint, to calculate this expectation, a set of future states (or scenarios) must be posited, each with a probability of occurring and a credit loss amount attached to them. The ECLs are then estimated as the sum of the credit loss incurred in each scenario multiplied by the probability of the respective scenario occurring. Next, we illustrate how to apply this methodology in Example 1.

Example 1: The future contractual cash flows for an existing loan are $100,000 (assuming no changes in interest rates and that the borrower makes the payments agreed upon in the contract). If the company identifies a scenario in which a default would occur with a likelihood of 1% and where the estimated cash flows to be received would be $1,000, then this scenario would contribute $990 to the overall ECL (i.e., the product of the shortfall of $99,000 and the chance of this scenario occurring of 1%).

For a financial asset, the ECL is thus the difference between the total value of the promised contractual cash flows and the total value of the expected cash flows discounted at the effective interest rate (as defined by IFRS 9) at initial recognition. Note that even when the total payments are expected to be received in full, but with a delay, there would still will be a certain amount of ECLs due to the time value of money. In other words, the promised cash flows must be paid in the same amount and timing as stipulated in the financial instrument contract; otherwise, the ECLs will be greater than zero.

IFRS 9 Approaches to Expected Credit LossesAccording to IFRS 9, entities can apply one of three approaches for measuring and recognizing ECLs:

General approach: Applies to all the assets not eligible for the other two approaches.

Simplified approach: Required for qualifying trade receivables and for contract assets within the scope of IFRS 15 Revenue from Contracts with Customers. Otherwise, it is optional for other trade receivables and for lease receivables.

Credit-adjusted approach: Applies to assets that are credit impaired at initial recognition (e.g., loans purchased at a deep discount due to their high credit risk).

The general and simplified approaches are practical solutions introduced by the International Accounting Standards Board to address concerns about the effect of interest income on revenue recognition, cost and complexity, as well as to mitigate the effect on current systems.

General Approach and the Three-Stage Decision Tree
At initial recognition of a financial asset, 12-month ECLs are recognized in the P&L while a loss allowance is established. In subsequent reporting periods, a critical factor when implementing the general approach is the comparison of the current credit risk of the asset relative to the credit risk at the date of initial recognition. If an asset’s credit risk has not deteriorated significantly over time (i.e., the asset is still in ‘Stage 1: Performing’ as it was at inception), then the firm is allowed to use the 12-month ECLs.4 Otherwise, lifetime ECLs are taken in Stages 2 or 3 of the model. This is illustrated in further detail next.

Exhibit: Stages in the impairment model for financial assets (a function of changes in credit risk since initial recognition)

ECLs are updated at each reporting date for new information and changes in expectations, even if there has not been a significant increase in credit risk.

‘Stage 2’ applies to assets that have experienced a significant deterioration in credit quality since initial recognition, but that do not exhibit any objective evidence for credit impairment. On the other hand, ‘Stage 3’ applies if there is objective evidence of credit impairment (e.g., default is imminent or has already occurred)5. An entity is required to estimate the lifetime ECLs rather than the 12-month ECLs for assets in ‘Stage 2’ and ‘Stage 3’, but they differ in the calculation of the interest revenue. In ‘Stage 3’, interest revenue is taken at the net carrying amount (i.e., net of the ECLs), while in ‘Stage 2’, no interest revenue is based on the asset’s gross carrying account.

The Simplified ApproachThe simplified approach applies mandatorily to trade receivables that do not have a significant financing comment. In addition, the entity has the option to apply this approach to trade receivables that have a significant financing component and to lease receivables.

Under the simplified approach, an entity recognizes a loss allowance based on lifetime ECLs rather than by using the process described earlier under the general approach.

As a practical expedient, for the purposes of calculating ECLs under this approach, IFRS 9 allows entities to use a simplified ‘provision matrix’, but only if it is consistent with the general principles for measuring expected losses. To construct a ‘provision matrix’, the entity would use its historical credit loss experience and make adjustments (as appropriate) for forward-looking estimates. The ‘provision matrix’ relates various groupings of the trade receivables (or other assets) in the portfolio based on their characteristics to each group’s expected default rate. The product of the default rate associated with a given grouping and the gross carrying amount of the assets (e.g., trade receivables) within such a group would result in the lifetime ECLs. The ‘provision matrix’ is dynamic, and up-to-date default information is incorporated on every reporting date.

In Example 2, we illustrate with an example how to implement the simplified approach with the ‘provision matrix’.

Example 2

State of the Trade Receivable

Performing

1 to 30 days past due

31 to 60 days past due

61 to 90 days past due

More than 90 days past due

Default rate = X

0.5%

2.0%

5.0%

6.5%

18.0%

Gross carrying amount (in $1,000s) = Y

24,000

21,500

12,500

9,000

2,500

Lifetime ECL = X * Y

120

430

625

585

450

It is worth noting that the simplified approach does not apply to intercompany loans.

The Credit-Adjusted ApproachThe credit-adjusted approach applies only in cases where an entity acquires or originates an asset that is ‘credit impaired’ at the date of initial recognition (note that if financial assets are acquired in a business combination, then the initial recognition date is reset to this acquisition date). A financial asset is credit impaired when one or more events that have a detrimental effect on the estimated future cash flows of that financial asset have occurred. The standard lists several events that could provide evidence that a financial asset is credit impaired.6

Guidelines for the Application of the Expected Credit Losses Model

Definition of DefaultAlthough IFRS 9 prescribes modelling losses based on the occurrence of defaults, it does not provide a clear definition default. The Basel definition of ‘90 days past due’ is a likely maximum.7 Nonetheless, as IFRS 9 is endorsing a forward-looking approach, entities should recognize a default earlier if they have reasonable and supportable information that the borrower’s creditworthiness has worsened. Generally speaking, the definition of default should be consistent with the entity’s internal credit-risk management policies and procedures.

Increased Credit Risk and DefaultsAt each reporting date, an entity shall assess whether the credit risk on a financial instrument has increased significantly since initial recognition.
There is a presumption that when contractual payments are overdue by more than 30 days, then the credit risk on a financial asset has increased significantly since initial recognition. However, if historical and other data shows that 30-day past due delinquencies do not necessarily mean financial distress, then this assumption can be rebutted.

Low Credit RiskAn entity may assume that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date. IFRS 9 does not provide a definition for what constitutes a low credit risk. However, assets are eligible for the low credit-risk exception if the following conditions hold:

The risk of default is minimal.

The borrower has significant resources or collateral to be able to fulfil the cash flow obligations in the near term.

Adverse changes in economic circumstances and business conditions in the long term might, but will not necessarily, affect the borrower’s ability to honor the contractual payments.

A practical expedient adopted by market participants is to assume that assets with an external ‘investment-grade’ rating (e.g., ratings within the AAA through BBB categories using the Standard & Poor’s rating system) have low credit risk at the reporting date.

Undrawn Loan CommitmentsFor undrawn loan commitments, a credit loss is based in on the present value of the difference between the following:

the contractual cash flows that are due to the entity if the holder of the loan commitment (i.e., the borrower) draws down the loan; and

the cash flows that the entity expects to receive if the loan is drawn.

In order to estimate ECLs on loan commitments, the entity needs to estimate the expected portion of the loan commitment that will be drawn down within 12 months of the reporting date versus over the expected life of the loan commitment. The entity can then use this analysis to estimate the 12-month and the lifetime ECLs, respectively, by applying the same methodology under the general approach explained earlier.

CollateralCollateral generally plays a limited role in assessing whether there has been a significant increase in credit risk. However, it affects the calculation of the ECLs to the extent that the collateral and other credit enhancements that are part of the contractual terms are not recognized separately by the entity. For example, let’s assume that there has been a significant increase in credit risk since initial recognition and that the borrower is not expected to be able to repay the loan in full. If the expected proceeds from the collateral exceed the loan principal amount, then the entity will have zero ECLs and, therefore, will not need to recognize any allowance for the asset under the simplified assumptions that (i) there are no costs of obtaining and selling the collateral, and (ii) there are no timing differences when the cash flows resulting from the collateral would be received.

Forecasting InformationWhen measuring ECLs, the entity should perform an ‘unbiased evaluation’ (i.e., neither conservative nor optimistic) of a range of possible outcomes and their probabilities of occurrence. Therefore, there might be a mismatch between IFRS 9 forecasts and forecasts used for regulatory purposes (e.g., with respect to the probabilities of default (PD)). The latter demand a prudent approach, while IFRS 9 is endorsing an unbiased approach.

Furthermore, to achieve a reliable calculation for the ECLs, the range of possible outcomes (or scenarios) should be reasonable (i.e., the number of scenarios should be finite and not too large). When assessing the probabilities of these scenarios occurring, IFRS 9 prescribes the use of “reasonable and supportable information that is available without undue cost or effort”.8 This should include historical performance and supportable forecasts of future events and economic conditions (‘forward-looking approach’). As the time horizon increases, the uncertainty of the forecasts also increases. Forecasts should be extrapolated forward with all the available data, but all the assumptions and extrapolations made should be documented.

When assessing an asset’s credit risk, internal credit ratings can be used, but these must be in line with existing or prospective external credit ratings.

StratificationIf there is a sufficient statistical rigor, a portfolio of instruments with similar initial credit risk can be stratified, and the modelling can then take place at the sub portfolio level, allowing the increase in credit risk to be modelled in an aggregated way. This aggregated approach is necessary especially when there is not sufficient supportable information to look at the PD for individual instruments.

Entities should conduct groupings on financial assets with similar credit risk and other product characteristics, such as (but not limited to) the following:

Type of industry

Geographic location of the borrower

Type of instrument

Credit-risk ratings

Level and type of collateralization

Origination date

Term to maturity that remains

Ratio of collateral to the value of the financial asset

When calculating the ECLs on an aggregated level, a probability-weighted estimate is applied.

Hedge AccountingAnother significant change introduced by IFRS 9 relates to hedge accounting. The new standard introduces significant improvements by better aligning hedge accounting with the risk-management activities of an entity. For a more detailed explanation of how these changes will affect entities operating under IFRS 9, refer to See Private Debt Investments Under IFRS 9-All Roads Lead to Fair Value.
Broadly speaking, the new standard widens the range of exposures that can be hedged and establishes new simplified criteria to achieve hedge accounting. For instance, it allows aggregated exposures (i.e., a combination of exposures) that include a derivative to qualify as a hedged item. Furthermore, risk components of a nonfinancial item can now be designated as the hedged item in a hedging relationship, provided the risk component is separately identifiable and can be measured reliably.
In order to assess hedge effectiveness in cases where the hedging relationship is simple, entities are allowed to perform only a qualitative test, such as substantiating that the quantity and timing of the hedged item match the hedging instrument.
In cases where the hedging relationship is more complex, a detailed quantitative test will most likely be required to determine hedge effectiveness (e.g., determining an appropriate hedge ratio and/or establishing if an economic relationship exists between the assets).

DisclosuresIFRS 9 amends the disclosure requirements of IFRS 7. These updates relate to the classification and measurement of financial assets and liabilities, impairment and hedge accounting.

Under the classification and measurement disclosures, a significant issue is the treatment of an entity’s ‘own credit risk’ for financial liabilities. Special relevance is also given to the derecognition of financial assets measured at amortized cost that result in gains and losses, and the disclosures must highlight why amortized cost assets are derecognized before maturity.

Additional disclosures will be required on credit-risk management practices and credit-risk exposures. In particular, firms will need to provide extensive qualitative and quantitative information on changes in ECLs.

Assistance with the resolution of audit items or regulatory findings related to financial, risk-management or capital management reporting

1.Early adoption is permitted, and delayed adoption is permitted for certain entities, primarily in the insurance industry.2.Unless the asset is designated at FVPL under the fair value option to eliminate or reduce an accounting mismatch.3.Investment entities should report all investments, including debt investments at fair value. 4.Note that the 12-month ECL is not a measure of the expected shortfall of cash flows over the period, but the expected losses due to defaults occurring in the 12-month period relative to the lifetime of the asset (i.e., a portion of the lifetime expected credit losses due to the possibility of defaults occurring within 12 months of the reporting date).5.IFRS 9 provides a definition of a credit-impaired asset and examples of observable data and events that offer evidence that an asset is credit impaired.6.See also IFRS 9 Appendix A.7.This assumption is rebuttable in those (very rare) occurrences where there is reasonable and supportable information.8.This is outlined in paragraph B5.5.15 of IFRS 9.